A simple investing strategy has played a major role in driving Warren Buffett’s wealth to about $160 billion, according to Forbes. The strategy is called value investing and today’s version is based on methods taught by Benjamin Graham, the originator of value investing and an early mentor to Buffett.
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The strategy takes patience and due diligence, but its techniques are widely available to all investors, even complete beginners.
What Is Value Investing?
Value investing selects stocks by analyzing a company’s financial information to determine the stock’s intrinsic value. If the value is higher than the current share price, the investor considers the stock to be undervalued and therefore a potentially good investment. The idea, as the Corporate Finance Institute (CFI) explained it, is that the market will eventually correct the price of the stock to a level that reflects its value based on supply and demand.
How To Identify Value Stocks
Value investors use several different financial metrics to determine a stock’s intrinsic value. BlackRock, for example, uses the following.
Price-to-Book Ratio
The P/B ratio tells you how much investors are willing to pay for each dollar of the company’s net assets. A low ratio suggests a stock is undervalued, but it doesn’t tell you why the price might be low.
Price-to-Earnings Ratio
The P/E ratio compares a company’s stock price to its 12-month expected earnings and it adds context to the P/B ratio. To use it, look at the company’s ratios over time to see if the current ratio is near historic lows. If so, the stock might be undervalued. You can also compare the current P/E ratio to the ratios of similar companies. Again, if it falls at the lower end of the scale, it could mean the stock is undervalued.
Enterprise Value to Cash Flow From Operations
This metric helps you evaluate a company’s cash flow. As with the other ratios, it’s a tool of comparison between the company you’re interested in and similar companies in the same industry. A low ratio could indicate a stock is overpriced.
According to CFI, here’s how to find it:
- Calculate the enterprise value of the company: value of the outstanding shares + debt – cash flow.
- Divide the enterprise value by operating cash flow, which you’ll find on the company’s cash flow statement.
Yahoo Finance and other sites with stock information have all the information you need to identify value stocks. As you research different companies, you’ll find that they typically have three things in common:
- They’re well-established companies with long track records of growth.
- They often pay dividends.
- They’re less vulnerable to market volatility compared to growth stocks.
Buffet’s Advice for Picking Stocks
As seen in this YouTube video, Buffett has been remarkably consistent in his advice for investors wanting to follow his techniques for picking stocks.
- Think of a stock as part of a business, then invest in the business, not “the market.”
- Look for “moats” — companies with sustainable competitive advantages. Walmart and Disney are good examples. It seems unlikely that either would be knocked off its pedestal by a competitor.
- Invest in what you know and understand — your sphere of knowledge is your margin of safety.
- Ignore the experts except to profit from their “folly,” as Buffett calls it. Their sell-offs are your opportunities to buy and their buying frenzies are your opportunities to sell.
- Never bet against America. “We come through things, but it’s not always a smooth ride,” Buffett, then an advisor to President-elect Barack Obama, said to ABC in 2009.
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This article originally appeared on GOBankingRates.com: Could Warren Buffet’s Value Investing Strategies Work for Today’s Beginners?
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